Energy law firm details three trends that could upend energy companies in 2019

Among the top three trends that could bring litigation risks to energy companies in 2019 is hydraulic fracturing and the rising risk of “frac this” that could interfere with another operator’s neighboring well.

Among the top three trends that could bring litigation risks to energy companies in 2019 is hydraulic fracturing and the rising risk of “frac this” that could interfere with another operator’s neighboring

Among the top three trends that could bring litigation risks to energy companies in 2019 is hydraulic fracturing and the rising risk of “frac this” that could interfere with another operator’s neighboring well.

Among the top three trends that could bring litigation risks to energy companies in 2019 is hydraulic fracturing and the rising risk of “frac this” that could interfere with another operator’s neighboring

Energy law firm details three trends that could upend energy companies in 2019

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A new year is on the horizon, and with it will come new challenges.

There are three main trends oil and gas companies should be on the lookout for in 2019, according to the energy law firm Baker Botts.

These trends could not only expose companies to litigation and the resulting financial exposure, but could put corporate assets at risk, said Jason Newman, partner with the company.

Allocation disputes

That is especially true of oil and gas allocation disputes, and the unprecedented growth of shale plays has made dividing up those royalties more complex than ever, Newman said.

"It used to be that if you didn't pay royalties properly, you could face damages, but the lease would not be terminated," he said in a phone interview from his Houston office. "Leases today make not paying royalties properly a cause for termination. That's changed. Operators could budget for minimizing the risk of royalty disputes, but this puts their assets at risk."

Newman attributed the complexity of dividing up royalties to technological advances. Operators are drilling horizontal wells with longer laterals across multiple leased tracts or multiple pooled units, he said. Those long laterals bring up questions about how the wells should be permitted, whether the underlying leases allow "allocation" wells and how royalties should be calculated across the various leases when production is aggregated at surface processing and storage facilities. The leases that operators are using to drill wells, especially in the Permian Basin, don't express how production should be allocated, he said.

In addition, he said the Permian Basin has been producing oil and gas for almost a century, and royalty interests in the region are highly fractionated.

"The problem of allocating royalties from horizontal wells is a legal issue without clear answers from the courts. That puts operators in a tough spot," said Newman, noting that the courts have not kept up with technological advances.

"The theory a lot of plaintiffs are using (in shale plays) is that if the oil and gas company can't tell with certainty where the oil and gas comes into the wellbore, maybe it's not a question of 'You didn't pay me enough, someone else got too much.' This is not reallocating the pieces within the pie; this is trying to make the pie bigger."

Decisions are often made "on 50 years of jurisprudence based on vertical wells. Technology has changed so rapidly the courts can't keep up," he said.

Regulators are trying to help address the issue, he said, noting the Railroad Commission now issues permits for wells with production sharing agreements if 65 percent of acreage owners agree on a royalty formula.

The commission will also issue permits for true allocation wells, in which less than 65 percent of owners agree to a royalty formula. "That's the riskiest approach," Newman said.

Savvy operators are being proactive by updating leases and looking at how production will be allocated beforehand, he said.

Operators today are designing higher-pressure completions using more proppants, but this modern technology also raises the potential for frac hits where a new well interferes with a nearby well or historical vertical wells. This also raises the potential for large claims for lost production, equipment damage and environmental contamination.

The issue is particularly acute in the Permian Basin, where operators have inventories of thousands of drilling locations in areas where historic wells already exist, he said. These older wells, drilled as far back as the 1940s, don't have the mechanical integrity to withstand a frac hit as do newer wells, Newman said.

"Frac hits do end up in court," said Newman. "They're tough cases."

The cases may not give rise to the standard of trespassing but could meet the standard for a negligence claim.

Courts are struggling to answer questions, such as what is the state-of-the-art standard of care in avoiding frac hits and legal issues involving predecessor interests, contractual indemnities and regulations on plugging wells.

"Technology is evolving so rapidly you can't find an expert engineer to discuss the specifics," Newman said. "It's an issue of trying to talk in reasonable terms about what's happening underground."

Price volatility

Unlike royalty allocations and frac hits, which have been impacted by technology, price volatility has been with the industry since the first barrels of oil were produced, said Newman.

Price volatility has surged significantly in recent months. After reaching a four-year high in October, prices have plunged 40 percent to levels seen in the price collapse of 2015-2016. Newman said 2019 could be a test for producers who boasted of breakeven price ranges between $30 and $40 a barrel in the shale plays.

"In the latest downturn, a lot of companies have advanced technology where they can drill either longer laterals or, in the Permian Basin, tap multiple reserves from a single well. I think for the same capital, drilling companies can end up with a well producing more. (But) those wells are based on a price range," he said.

If prices fall further or remain low, he predicted a chilling of activity or a spike in bankruptcies, which could lead to insolvency disputes, joint venture disputes or borrower-lender liability claims.

As an attorney focused on energy issues, Newman said he finds the issues very interesting. He also draws from personal experience. He said his family is from West Texas and "my personal family has gotten royalty checks for 2 cents, with a 35 cent postage stamp."

Pondering the three trends to watch for, he said it will be interesting to see where courts will go on the issues.

"The trial courts have a tough job. They don't have a lot of appellate findings to go by," he said.

He said that rulings won't be "the sky is falling but could be a disincentive to development."

Mella McEwen is the Oil Editor and covers the latest business and energy news. You can read more from her here. |mmcewen@mrt.com|